Unlawful Securities Transactions and Scienter: an Emasculating Requirement

• Jurisdiction: United States,Federal
• Citation: Vol. 1 No. 03
• Publication year: 1978

UNIVERSITY OF PUGET SOUND LAW REVIEWVolume 1, No.1FALL 1977

Unlawful Securities Transactions And Scienter: An Emasculating Requirement

David Strout

Recognizing that most people are unfamiliar with the complexities of corporate organization and the intricacies of investing, the legislatures of all fifty states designed laws to protect investors from the dishonest schemes of unscrupulous securities promoters.(fn1) Because of the diverse approaches the states took to regulate the offer, sale, or purchase of securities, the National Conference of Commissioners on Uniform State Laws drafted the Uniform Securities Act(fn2) to achieve a substantial degree of uniformity(fn3) among those states assimilating its provisions. Although uniformity was a paramount objective,(fn4) the Uniform Act's drafters, realizing the impracticality of complete uniformity among the states,(fn5) provided options to permit expression of each state's individual regulatory policy.(fn6) In 1959, the Washington Legislature adopted a modified version(fn7) of the Uniform Securities Act.(fn8) A Washington appellate court, however, recently diminished the Washington Act's protective scope.(fn9)

This comment suggests the proper construction of the unlawful transactions provision(fn10) of the Washington Act and rejects scienter as a necessary element of a violation of that provision. The discussion necessitates consideration of federal rule 10b-5,(fn11) because the rule is the source of the Uniform Act's unlawful transactions provision. The focus, however, is on the inapplicability of the United States Supreme Court's analysis in Ernst and Ernst v. Hochfelder (fn12) to the Washington Act's construction.

Massive fraud in securities transactions, culminating in the stock market crash of 1929, demonstrated the need for comprehensive securities regulation.(fn13) Congress designed the Securities Act of 1933(fn14) to insure an investor's access to pertinent facts concerning securities offered for sale and to protect against fraud and misrepresentation in securities transactions.(fn15) The Securities Exchange Act of 1934(fn16) increased investors' protection, substituting "a philosophy of full disclosure for the philosophy of caveat emptor . . . to achieve a high standard of business ethics in the securities industry."(fn17) Because Congress devised the Acts to protect the public from speculative or fraudulent schemes, and because they are remedial statutes, congressional intent requires that they be given a liberal construction.(fn18) Section 10(b)(fn19) of the 1934 Act makes it unlawful for any person, while purchasing or selling any security, to use or employ a manipulative or deceptive device or contrivance in contravention of the Securities and Exchange Commission's rules and regulations.

Acting pursuant to section 10(b), the Commission promulgated rule 10b-5,(fn20) which it intended for use in injunctive proceedings rather than in private damage actions.(fn21) Notwithstanding the Commission's intent, courts have recognized private damage actions under rule 10b-5.(fn22) Because neither the statute nor the rule indicates the elements in a private suit, courts have had difficulty defining rule 10b-5's scope. The elements most commonly considered essential in private 10b-5 actions are: misrepresentation or omission, materiality, scienter, reliance, and causation.(fn23) The element of scienter, in particular, has presented problems for the courts because of varying, often imprecise and contradictory uses of the word.

In misrepresentation actions, common law traditionally defines scienter as the intent to deceive, mislead, or convey a false impression.(fn24) Although some courts have employed the intent to deceive definition of scienter in 10b-5 cases,(fn25) most federal courts have defined scienter to include other states of mind, such as recklessness,(fn26) actual knowledge of falsity,(fn27) negligence,(fn28) or lack of due diligence.(fn29) In one opinion the United States Supreme Court defined scienter as intent(fn30) or knowledge,(fn31) but also suggested recklessness may supply the scienter element.(fn32) Scienter creates further confusion because a court may require varying degrees of scienter depending upon the factual setting and the relief sought.(fn33)

Prior to 1976, the United States Courts of Appeals had split on the issue of whether scienter was an essential element of a 10b-5 violation.(fn34) The Ninth Circuit Court of Appeals consistently rejected the necessity of proving scienter(fn35) and, in White v. Abrams,(fn36) suggested the proper consideration is the extent of the duty to disclose that rule 10b-5 imposes on a particular defendant.(fn37) White instructed district courts to measure the extent of defendant's duty by a flexible standard. This standard required courts to focus on the goals of securities fraud legislation, by considering factors previously found significant in securities transactions(fn38) and all factors relevant to the particular case.

The United States Supreme Court addressed the scienter issue in Ernst and Ernst v. Hochfelder,(fn39)" and concluded that absent some form of scienter, a private cause of action for damages will not lie under section 10(b) and rule 10b-5.(fn40) Justice Powell, writing for the majority,(fn41) emphasized section 10(b)'s language, which makes unlawful the use or employment of "any manipulative or deceptive device or contrivance" in contravention of SEC rules. He suggested the words "manipulative" or "deceptive" used in conjunction with "device" or "contrivance" indicate section 10(b) was directed at knowing or intentional misconduct and make unmistakable a congressional intent to proscribe a type of conduct different from negligence.(fn42) Justice Powell found the word "manipulative" particularly significant, suggesting it is virtually a term of art that, when used in connection with securities markets,(fn43) connotes intentional or willful conduct designed to deceive or defraud investors.(fn44)

Although asserting the statute's plain meaning might make further inquiry unnecessary,(fn45) Justice Powell drew additional support from the Act's legislative history.(fn46) Legislative reports indi cated Congress intended good faith to be a defense under those sections of the 1934 Act creating express civil liability for manipulative practices.(fn47) Accordingly, he concluded that good faith is a defense in suits brought under section 10(b)'s implied right of action.(fn48)

Justice Powell argues most persuasively for scienter as a necessary 10b-5 element when he discusses the 1933 and 1934 Acts as interrelated components of the federal regulatory scheme governing securities transactions.(fn49) In many of the provisions expressly creating civil liability in securities transactions, Congress clearly specified whether knowing or intentional conduct, negligence, or innocent mistake is culpable conduct.(fn50) Congress also created procedural restrictions limiting purchasers' and sellers' ability to sue under these provisions.(fn51) Rule 10b-5 has no comparable restrictions; therefore, if courts do not require some form of scienter, causes of action arising under the express liability provisions could be brought instead under the judicially created private damage remedy of rule 10b-5. This practice would nullify other provisions' procedural limitations, thereby disrupting the federal regulatory scheme and circumventing congressional intent.

Because of the similarity in language between Washington's unlawful transactions provision(fn52) and rule 10b-5, Washington courts have looked to federal precedent when construing the Washington statute. In Shermer v. Baker, (fn53) the Washington Court of Appeals first considered whether scienter is necessary for a violation of the unlawful transactions provision. The court relied upon Ninth Circuit decisions holding proof of common law fraud, particularly the element of scienter, unnecessary to establish a 10b-5 cause of action.(fn54) Although noting the Ninth Circuit's interpretation of a similarly worded federal statute was not determinative of state law, the Washington court held plaintiffs reliance upon a material misrepresentation or omission established a cause of action under the unlawful transactions provision and proof of defendant's intent to deceive is not required.(fn55)

The same appellate court recently reconsidered the "no scienter" interpretation of the unlawful transactions provision in Ludwig v. Mutual Real Estate Investors.(fn56) Ludwig impliedly overruled the court's previous interpretation and offered two grounds for limiting "fraud," as used in Washington's Securities Act, to its common law meaning.(fn57) First, when the Legislature uses a term without defining it and the term has a well known common law meaning, a presumption arises that the Legislature intended the common law meaning.(fn58) Second, the United States Supreme Court in Ernst and Ernst overruled the Ninth Circuit line of cases upon which the Washington court relied for its "no scienter" holding.(fn59)

At common law, a plaintiff may recover damages incurred in the purchase or sale of securities under theories of (1) fraud and deceit, (2) constructive fraud or negligent misrepresentation, (3) liability based upon half-truth, and (4) liability based upon breach of fiduciary duty.(fn60) The first theory, fraud and deceit, requires scienter. In nonsecurities...